JSW Steel Ltd’s deal to acquire Ispat Industries Ltd was expected, as reports about the deal were in circulation for days. Still, the deal held out some surprises, pleasant for some but not for all. Recent buyers of Ispat’s shares discovered the risks of punting on deal news, as its share price fell by about 15% on Tuesday.

JSW settled for a lower stake in Ispat, not wanting to pay a premium, but came up with an innovative structure that works to the benefit of key stakeholders. It will invest 2,157 crore in Ispat for a 41% stake through a preferential allotment. The money, therefore, moves out of its balance sheet and into a company, which it will anyway control.

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Lenders already own an equity stake in the company, after converting debt, and also have pending conversion rights. Their dues of 7,500 crore will be repaid within nine months through a refinancing deal. But they are holding to their equity holdings for a better price. The Mittals’ stake will fall to about 26%. JSW will be in the driver’s seat, controlling two-third of board appointments, thus making the open offer more of a technicality.

What do the Mittals gain? This is a far better outcome than an asset stripping exercise. The lenders are off the company’s back. They still retain a significant stake. And, if JSW’s plans for turning around Ispat succeed, they will get a higher price whenever they decide to exit. Their chances of a profitable exit are aligned with JSW’s intention to turn around Ispat, ensuring unity of purpose between the two main shareholders, making the deal more likely to succeed.

JSW’s first priority is to restart Ispat’s steel plant, using the funds from the preferential allotment as working capital. Next, it intends to make Ispat profitable in 12 months. That’s an ambitious target; in the quarter ended September 2010, it incurred a net loss of 332 crore compared with a loss of 322 crore in the 15 months ended June 2010.

JSW expects the debt refinancing to lower interest costs by 4 percentage points or about 300 crore. That will cut losses considerably. JSW understands this business very well and has been running a very profitable steel business compared with Ispat. Initially, it intends to use their combined scale to lower Ispat’s sourcing costs of key inputs such as coke, pellets and power. Though not stated, it will seek other common areas to improve sales growth and lower costs.

Running the plant at full capacity (Ispat’s plant operated at 80% in fiscal 2010) itself will improve the operating parameters. The hot rolled coil capacity will be expanded by 27% to 4.2 million tonnes. In addition, Ispat has started work on setting up a coke oven plant, a pellet plant, and a captive power plant. JSW will complete these projects. Once that happens, in about three-four years, Ispat’s profitability will improve further.

In the near term, however, Ispat’s performance will weigh down JSW’s financials too. The deal values Ispat at an enterprise value of about 13,000 crore, valuing it at 1.5 times fiscal 2010 sales. That may seem high for a loss-making company, but JSW has not overpaid in relation to Ispat’s market price. JSW’s capacity rises by one-fifth, an advantage considering how much time and effort is involved in building a new steel plant. Capacity expansion at Ispat is another future possibility. Ispat also has some early-stage mining projects, for iron ore and coal, which could be bonuses, if they become operational.

JSW’s share price rose by 2% as shareholders were pleased at their company not paying over the top for Ispat. Consolidation of Ispat’s loss-making business may take some of that pleasure away in forthcoming quarters. If JSW is able to demonstrate its ability to improve Ispat’s operations in the medium term, investors will have much to cheer.

Graphics by Yogesh Kumar/Mint

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